Friday, February 25, 2005

Buying Property in Bulk

I am interested in the Supreme Court case Velo vs. The City of New Haven, Connecticut, (link via Cafe Hayek). The controversy surrounding this case centers on the right of a municipality to use eminent domain to condemn private property for the purpose of reselling the land to a private real estate developer. According to the Fifth Amendment to the U.S. Constitution, governments can seize private property but they must pay just compensation and they are only entitled to seize property if it is to be used for public purposes. However, there is already precedent for local governments seizing land for the purpose of clearing blight, which, broadly interpreted, might mean seizing land that is more valuable as cleared land than in its current state. This definition of “blight” might include 10% to 25% of the land within 10 miles of the U.S. Capitol, for example, so this is a somewhat awesome prospect. If you live in an older home, the government might decide they want it. Your property rights are null in the eyes of the government.

This issue has caused considerable consternation in the blogosphere, from libertarians to progressives. For blogs that have posted on it include Cafe Hayek, Crooked Timber, Coyoteblog, to name a few. No one seems very comfortable with government just seizing land in this way. A large part of this unease is that there seems to be many people whose property was seized that did not receive what they considered just compensation. Just compensation is subjective; some people would not sell their house for 200% of its estimated value because of sentimental reasons. On the other hand, some people in this situation might exaggerate their losses.

In defense of eminent domain

Why do real estate developers need the government to get land, land that the government takes by force? It certainly sounds terrible. However, if you want to have stadiums and big buildings conveniently located in the city center, there might not be any other way than to at least threaten homeowners with eminent domain. The problem is that acquiring large amounts of land by voluntary negotiation will lead almost certainly to politics and a breakdown in negotiations. There is a terrible monopoly situation associate with collective agreement: any homeowner can nix the deal by just being either stubborn or greedy or both.

Suppose, for example, that a real estate developer has his eye on about 500 properties covering maybe one square mile. Now suppose that this developer would be willing to pay up to 20% more than the estimated value of the properties to acquire the land. If just one person is obnoxious and insists on double the estimated value, then maybe she gets it, and everyone else gets 19.8% of her estimated value. But if one person gets away with it, then everyone will want a special side deal and the whole purchase will collapse.

The game I outlined above has a strong similarity to the classic “tragedy of the commons” in which individual rationality leads to collective insanity. The real estate developer only cares about the average price of the 500 homes. Each homeowner only cares about the price of her home. If a homeowner asks for an extra 10% more for her home, and all homes are similar in value, then the average home price goes up only 0.02%. So everyone thinks, “No one will notice if I ask for a little more.” If a few conscientious homeowners “do the right thing” and lower their asking price to save the deal, it won’t help much.

Another factor to consider is that many people are in deep denial about the value of their home. If one were to visit the various open houses on any weekend, one would encounter maybe one home in ten that has been on the market for months and is overpriced. Why don’t they drop the price? They will eventually, but they are convinced that the right buyer will come and see the hidden charms in the home that the homeowner sees. These people are going to be tough to negotiate with.

I have heard of an example of 14 homeowners voluntarily selling their homes to a real estate developer. I consider 500 homeowners voluntarily selling their homes to be a fairy tale.

The 10% punishment mechanism for acquiring land in bulk

A mechanism is a redesign for a game that leads to a desirable outcome. In the above game, the outcome was undesirable because one obnoxious person could destroy a deal worth maybe $200 million. We want the mechanism to produce an outcome that:

gives a high probability of yielding a successful negotiation when the benefits to the real estate developer exceeds the sum of the reservation prices of the property owners

yields mutual benefits to homeowners and the real estate developer

gives as many homeowners as possible their desired price.

The mechanism I propose I call the “10% punishment mechanism” because 90% get what they ask for and 10% are “punished” for asking for too much. In the first stage of the mechanism, the real estate developer notifies the homeowners that he wants to buy their land and if they refuse to deal with him, they will go to the government. Faced with the prospect of getting only “fair value” instead of probably 5% to 10% above fair value, probably everyone will agree, but one never knows. Let us assume that people are rational and they agree to the mechanism. Then, whatever happens, these homeowners are committed to selling the home at the price that the mechanism produces.

The second stage of the mechanism is the home price estimation. There are firms that can estimate home prices based on recent sales. If a homeowner objects to the estimated price, he or she can re-estimate it at the homeowner’s expense. The third stage is for each homeowner to submit his or her own home desired price. An independent evaluator orders these bids on the ratio to the homeowner’s price to the estimator’s price. The mechanism rule is that real estate developer must pay the homeowner’s price for the lowest 90% of bids, but the highest 10% are punished and get only the estimator’s price. I would amend the punishment rule to not punish anyone who is within 5% of the average bid, so if everyone bids 12% above the estimated value of the property, no one will be punished.

The real estate developer then looks at the total price and decides if it exceeds his reservation price for the property. If it does exceed his reservation price, the deal falls apart. Otherwise, the real estate developer signs the deal and we have a sale.

The 10% punishment rule would be extremely effective in discouraging greed on the part property owners. They might ask for 5% over the estimated price, because the mechanism guarantees them at least the estimator’s price in any case. However, asking for 10% might be like throwing away a bird in your hand to chase after two in a bush. The government would have to make it illegal for homeowners to pay other homeowners to “overbid.”

If some real estate developer came to my family with the 10% punishment mechanism, I think I would be comfortable with it. I’m not so attached to my home that I put a valuation for it that is in excess of the market. I might even make a nice profit off of the deal. However, it would make much more sense to try to acquire those junky homes down the road.